Pitcairn Investment Team Views on “BREXIT”

June 24, 2016 – The UK has voted to leave the European Union after 40 years of membership, defying the expectations of most market participants and ignoring the warnings from the International Monetary Fund and other leading economists regarding the negative impacts on trade.

As The Economist points out, the European Union accounts for roughly 45% of Britain’s exports and a decision to leave the Union puts this trade in some jeopardy. According to the Wall Street Journal, Britain’s trade of goods and services with the European Union in 2015 was £223 billion (44% of the UK’s total exports). This trade under current agreements does not have any tariff or tax on it and in the future, these trade deals will have to be renegotiated but could result in a deterioration in exports and a negative impact on UK growth. However, there are models already in place in Europe such as the trade deals that Norway and Sweden have with the European Union that suggest that most trade could continue with the EU without tariffs, but where some products may be subject to additional tax. Norway is a member of the European Economic Area (EEA) and contributes to the EU’s budget and allows the free movement of people. Many expect that this model would be most beneficial for the UK now that they have voted to leave the European Union.

Market reaction was swift, with the pound falling to 30-year lows and the significant sell-off in both UK and European equities, particularly in the financial services sector where the economic implications will be felt most.

On the political front, the vote was a clear message to the establishment that the “status quo” is no longer preferred and it is time for a change. Immigration has been at the center of the frustration that led to this vote to leave. This has led to the resignation of David Cameron as Prime Minister of the UK and a criticism of his handling of the referendum and the failed campaign to remain in the EU.

The immigration issue is not only a UK issue, but also one that will likely influence elections across Europe and in the US as well. The growing populist movements in many developed market economies such as France, Italy, and The Netherlands are likely to strengthen, leading to more uncertainty in markets. Interestingly, the leave votes were strongest across most of England, particularly in the North and Southwest of the country, but London and the surrounding towns voted overwhelmingly to remain. This suggests that the views from the financial center of London and the economic rationale for staying in the European Union was strong, but the rest of the country’s concerns over immigration and the free movement of people were of primary importance.

Financial Market Impact

The decision by the UK to leave the European Union has impacted financial markets immediately even though the process of exiting will occur over many years. There has been a “risk-off” trade across the global markets, particularly within the European bond market where German 10-year bond yields fell to a record low of -0.15% before recovering slightly back to positive territory. In the UK, the 10-year bond yield has declined to about 1.09% despite the fact that Standard & Poor’s have cut their credit rating on the country. This does not indicate confidence in the markets, but rather a view that the Bank of England will cut rates and the economic growth in the UK will slow and perhaps drop into recession.

US Treasuries have again benefited from this flight to safety as the US 10-year bond yield fell below 1.5% before recovering slightly. Gold, which has been strengthening on the back of declining bond yields over the last six months continues to rise as investors look to safe assets. This also suggests that market participants expect that the Federal Reserve’s plans to raise their Fed Funds rate later this year may again be put on hold. However, risk assets across the world along with peripheral European bond markets have sold off, with Italian, Spanish, Portuguese, and Greek bond yields widening as they did during the Euro crisis of 2011.

Pitcairn’s View

While the UK leave vote has generated volatility and a flight to safety trade in the short term, it has not altered our long-term outlook on global markets. However, there will be volatility and negative impacts on portfolios until the economic and financial impacts of this decision are better understood.

We maintain our low growth, low interest rate, low inflation outlook and this has not changed that outlook over the long term, but it re-affirms this view.

We would expect that the world’s global central banks will remain accommodative and this will continue to support financial markets and takes the potential for a policy mistake of tightening rates too soon off the table in the medium term.

Within global equities, Pitcairn continues to favor the US stock market versus non-US markets, although we continue to believe that exposure to the non-US equity markets offer attractive return opportunities in the long run, particularly as the UK begins the long process of renegotiating trade deals with the European Union.

We expect increased volatility as a result of this decision over the coming weeks. Today’s sell-off in the global equity markets have mainly reversed last week’s rally, but we believe that market values will ultimately stay above those in February.

The immediate impact on economically sensitive sectors such as financials, industrials, and material goods has been negative and has exacerbated the weakness we have seen in these sectors over the course of the last few quarters.

US-based earnings had been recovering from the impact of a falling oil price and the strengthening US dollar. The US dollar has strengthened against sterling as a result of the vote, but we would expect that the move overnight will bounce off of its lows.

We have seen a dramatic move in the US treasury markets, particularly longer-term bonds, which has effectively flattened the yield curve further. Typically, a flatter yield curve has signaled recession risk, but in this case we see the flatter yield curve as a function of the lower bond yields available in global markets, particularly in Germany and the UK.

In the end, this is more of a social and political event than it is a market event. However, these type of events can have a short-term impact on market volatility and as we move into the election season in the US, we may see this volatility emerge again.